These changes require all participants to fundamentally revisit their business and operating models, and place huge demands on their capacity to implement what is required. In addition the burden of regulation has dramatically increased and continues to do so, requiring much more rigour and resource bandwidth.
We expect to see a few, large institutions remaining active across all capital markets product areas. Many more will select a limited range of activities based on where they believe they have comparative advantage – with other business areas being sold, mothballed or exited. The selection of core activities will require a clear understanding of the post-capital, tax and liquidity returns under the new rules, in the new market environment, of each product area. At present, the degree to which institutions are able to do this is mixed.
As the peer group work out what their businesses should look like in the future, they need to consider not just all of the regulatory developments but also market pressures and competitor responses, and what their key priorities are to maximise sustainable shareholder rewards. Significant market factors that will have a bearing include the impact of weak or non-existent economic growth on product demand, the effect of deleveraging on the buy side, the elasticity of demand for risk management products, the exit and consolidation of marginal players, the rise of shadow banking, and the exit of governments from the sector.
Derivatives market change
One of the most critical areas where regulation will impact is in the area of derivatives market change – driven by Dodd Frank in the US, Markets in Financial Instruments Directive (MiFID2) and European Market Infrastructure Regulation (EMIR) in Europe. Players are currently working out how they want to position in the new environment – where they face high entry costs and uncertain returns. Only the biggest players, with scale to absorb high technology costs and the ability to generate operational synergies, will benefit and there is likely to be a shakeout among remaining players.
Having come up with a revised business model, the operating model will need to be fundamentally rebased. Some key areas will be:
Governance and decision making
Regulators and shareholders expect more from senior management and boards. They are looking for improved governance, evidenced by better decision making, which is in turn informed by more rigorous information and challenge. Continued failures in this area show the industry is still a long way from where stakeholders would like it to be. Recent guidelines from the European Banking Authority (EBA) and coverage of governance in every significant policy proposal demonstrates the intention to keep up the pressure. Lack of progress on principles by the industry may result in something more prescriptive from regulators.
Legal entity strategy and structuring
The specifics of the regulations, and the drive towards subsidiarisation and self sufficiency by many regulators in both developed and developing markets is threatening the global booking model. Many of the permitted options will appear sub optimal, with an impact on which businesses are sustainable. While regulation is converging in Europe, global convergence remains more hope than reality. Differences may give competitive advantages to some businesses depending on where their home regulator is based.
Cost optimisation
There will be a need to build an industrialised, low cost operating model that can also meet regulatory and risk management needs. Businesses are fighting with such issues as right shoring, shared services, outsourcing, cost optimisation methodologies, revamped IT architecture, and procurement. An emerging issue is regulatory focus
on governance of more lean models, and the concern over the ability of the institutions to manage change. In addition, there is huge regulatory focus on the ability to provide continuity of service to core functions in times of stress.
Liquidity and capital planning
In the new world, these are scarce and expensive resources. Optimisation requires not just a re-think of resources but also an ability to price these correctly internally. The attractiveness of some customers and many business lines may no longer pass internal hurdles for returns in the face of these costs. Firms also need to prepare for the new rules set out in Basel 2.5 and 3. These will come through Capital Requirements Directive (CRD) 4 in Europe. We have entered an environment where established norms and practices of capital and liquidity risk management have been fundamentally impacted by the new regulatory agenda.The greater emphasis upon regulatory capital, particularly tier 1, compared to economic capital is but one example. Another is the focus by regulators on self sufficiency of liquidity and capital at an entity level – this will have wide ranging implications for globally active firms that have sought to manage financing of the group on a consolidated basis.
Data quality and availability
Transparency is the cornerstone of the new world financial order. Effective governance internally and effective supervision externally rely on timely, relevant and accurate information. But timely is now measured in minutes, not months, accuracy relies on consistency across hundreds (or thousands) of disparate underlying data sets and relevance is subject to a wide and growing interpretation by multiple regulators. To get this right and cost effective requires significant and sustained investment – which runs contrary to the immediate need to improve quarterly results. Best practice outcomes mean viewing data front to back and agreeing single ownership of key data sets across system silos.
Most of our clients have gone through the process of identifying their options in light of this new landscape. But these broad plans – if they are to be realised as intended – must be rigorously challenged by viewing them through five ‘lenses’ which will shed light on potential pitfalls and challenges.
The next couple of years at least will be very painful for the industry. However, the progress in resolving these issues ranges from a limited response to those armed with a range of options according to the final wording on the new regulation. For some, the scale of change will be overwhelming, driving consolidation and a reduction in capacity.
These factors should mean that even if the industry becomes smaller and margins overall do not recover, there will be players who are able to make superior returns for shareholders. A comprehensive and strategic approach to business and operating model change offers the opportunity for the industry to avoid the periodic very heavy losses that have blighted shareholder returns and share prices in the past, and instead build a sustainable platform which can balance the growth desired by shareholders with the stability sought by regulators.
